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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 38
We shall cover following topics in this hand out:
Types Of Currency Risks
o  Transaction exposure
o  Translation exposure
o  Economic exposure
Methods Of Protection Against Transaction Exposure
o  Internal Methods
o  External methods
Currency Risks
We can classify foreign risk exposure into three broad categories:
-  Transaction exposure
-  Translation exposure
-  Economic exposure
Translation Exposure:
In real world, a single transaction (sales and receipt) may take some period of time. For example, you sold
goods to a foreign customer on 15 December 2005, and customer promised payment after two months.
Now during these two months the exchange rate may fluctuate on either side and this will result in
exchange gain or loss. These transactions may include import or export of goods on credit terms, borrowing
or investing in foreign currency, receipt of dividend from foreign subsidiary. This type of exposure can be
safeguarded by using hedging instruments.
Translation Exposure:
When a business has several subsidiary located in different foreign land, then it needs to consolidate its
financial results of overall operations. Translation exposure effects the financials of the group when it
translates its assets, liabilities and income to home currency from various currencies.
The widely used mean of protecting against translation exposure is known as balance sheet hedging. In this
method, assets and liabilities are matched of offset in order to reduce the net effect of translation. For
example, a company may try to reduce its foreign currency dominated assets if it fears a devaluation of
foreign currency. At the same time, it may increase its liabilities by seeking loans in the local currency and
slowing down payment to creditors. The firm may try to equate its foreign currency assets and liabilities
then it will have no net exposure to change in exchange rates.
Economic Exposure:
This type of exposure affects the value of the company. Any adverse exchange rate fluctuation will reduce
the present value of all the future cash flow, thus reducing the value of the company. It is difficult to
measure the dollar value effect on the value of the firm.
For instance, a Pakistani firm is operating in other country through a subsidiary. Assuming that the foreign
country in question devalues it currency unexpectedly, this will be a bad happening for the home firm. This
is because every local currency unit of profit earned would now be worthless when repatriated to Pakistan.
On the other hand, if could be a good news as the subsidiary might now find it profitable to export goods
to the rest of the world.
If a firm manufactures all its products in one country and that country's exchange rate strengthens, the firm
will find its export expensive to the rest of the world. Sales will be stagnant if not lowering and the cash
flow and value of the firm will also deteriorate.
On the other side, if a firm has decentralized production facilities around the world and bought its inputs
from all over the world, it is unlikely that the currencies of all its operations would revalue at the same time.
It would therefore, find that although it was losing exports from some of its productions facilities, this
would not be the case in all of them.
When borrowing in more than one currency, firms must be aware of foreign exchange risk. Therefore,
when a firm borrows in US dollars it must settle this liability in the same currency. If US $ then strengthens
against the home currency this can make interest and principal repayments far more expensive. However, if
borrowing is spread across several currencies it is unlikely they will all move in one direction ­ upward or
Corporate Finance ­FIN 622
downward and economic exposure is reduced to considerable extent. Borrowing is foreign currency is
justified if returns will then be earned in that currency to finance repayment and interest.
Protection against Transaction Risk
Fluctuations in foreign exchange market do not stop. A company may have several thousand foreign
currency units in payable and receivable transactions. Such payments and receipts are going to take place in
future thus exposing a company to adverse fluctuations, resulting in exchange losses.
For example, a Pakistani enterprise is required to make US $ 100,000 to a US exporter within two months
time. The company anticipates that dollar will strengthen against the local currency (or local currency will
weaken against the US $), it means that Pakistani firm will need to spend more local currency units to buy
the dollars in question. This type of risk can be reduced if not eliminated, by hedging.
There are two types of measures that can reduce the transaction exposure. These are:
Internal methods:
-  Invoicing in home currency
-  Leading and lagging
-  Multilateral netting
External methods:
-  Forward contract
-  Money market hedges
-  Currency futures
-  Currency options
-  Currency swaps
Internal methods:
Invoicing in home currency
This will eliminate the need of exchange of currency upon receipt. However, the seller would be compelled
to revise its prices periodically.
Seller can invoice:
- In home currency
- Currency that is stable than home currency
- Currency with a positive forward markets
Buyer's preferable currency is:
- Own currency
- Stable than own currency
- Currency he has
- Currency of the industry
Leading & lagging:
- Leading refers to making payment before falling due.
- Lagging means to defer or delay the payment or settling the payment well past due date
If the currency of payer is weakening against the other currency (of buyer) than it is beneficial to
pay early. For example, if a Pak importer need to pay for import bill and predicts that Pak rupees
will weak against the dollar in future, then it is advisable to pay as early as possible.
However, if Pak rupee is foreseen strengthening against dollar, then delaying payment would be
financially advantageous.
These issues are from payer's standpoint and will be opposite for payee.
Matching of receipts and payments:
For-ex exposure can be partially hedged by matching payments and receipts of same currency.
For example, a company will receive US $ 1 million during the next quarter and will need to pay US
$ 1.2 million in the same period, and then the net exposure will be US $ 200,000/- as 1 million
payments and receipt are net off.
Corporate Finance ­FIN 622
Matching receipts and expenditures is a very useful way of hedging currency exposure. It can be
organized at group level by the finance department so that currency income for one of the group
companies can be matched with the expenditure of another company. In order to reduce the
transaction exposure to maximum level, it is of immense importance that forecast of amount and
timings of foreign currencies are reliable.
External Hedging Methods:
Forward Rate Agreements:
Under this method, hedging refers to making an investment to reduce the risk of adverse price movements
in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures
Using this method, we can fix the exchange rate now for a future transaction of the needed currency.
Because spot rates are changing every day and fixing the exchange rate for future date `now' reduces the risk
to significant extent.
A forward contract is binding upon both the parties ­ currency dealer and a company/client. This means
that both parties must honor their commitment to sell or buy the foreign currency on the specified date and
amount. By hedging against the risk of an adverse exchange rate movement with a forward contract, the
company also closes an opportunity to benefit from a favorable change in the spot rate.
Hedging is based on the assumption or estimate that it will be expensive to pay US $ in three months time
because of the fact the PKR will be weakening against US $. Therefore, a company enters into a contract to
buy x dollars after 3 months at an exchange rate of Rs 60/ US $ decided now. At the maturity date both
parties have to honor their respective commitments of buying and selling of US $ at agreed rates.
Now if on the maturity date, the spot ex rate is Rs 61/US $, (PKR weakened against US $), then the
company has actually eliminated the loss and benefited financially.
However, if the spot rate on maturity date is Rs. 59/US $, (contrary to its estimation of weak local currency,
local currency strengthened) then the company has missed the opportunity to benefit from this favourable
sport rate.
For best results, one must possess the knowledge of Forex market with a vision of future to estimate that
which currency will weaken against which other one.
Timing of cash flow is of crucial importance in hedging contract.
Money Market Hedging:
Money markets are wholesale (large-scale) markets for lending and borrowing of money for short term.
Bank are major player of money markets and companies seek their services to hedge against the ex rate
fluctuations in short term.
As forward ex rate (which is agreed now) is derived from sport rates using interest rates, a money market
hedge can produce the same results as of forward contract.
There will be two situations:
- A company is to receive money in foreign currency (FCY) at a future date and will exchange it into
local currency, and
- A company needs to pay foreign currency (FCY) at some future date and will use local currency to
buy the FCY to make payment
Scenario: Future Income in FCY
What is needed at this point is to fix the exchange value of the future currency income.
A hedge will be created by fixing the value of income now in local currency.
We can do it:
Borrow now in foreign currency (the same that the company will receive in future). The maturity of both ­
loan and receipt should be the same.
The loan + interest on FCY loan should equal the amount of FCY future receipt.
When the FCY receipt hit the account, loan will be paid off.
The FCY loan can be converted to local currency immediately and may be put to a short-term deposit to
earn interest.
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk